Allan H. Meltzer, University Professor of Public Policy at Carnegie Mellon University and Distinguished Visiting Fellow at the Hoover Institution, is the author of Why Capitalism? and A History of the Federal Reserve.

What’s Stopping Europe?

PITTSBURGH – On a recent visit to Greece, French President François Hollande declared that Europe’s decline was over, and urged French companies to invest in Greece. Bad advice. French production costs are high, but Greek costs are higher. Despite the considerable decline in Greek (and Italian and Spanish) real GDP since 2007, adjustment is far from complete.

In fact, one would be hard pressed to find broad agreement with Hollande’s assessment anywhere in Europe. Before the recent Italian election, financial markets showed signs of optimism, encouraged by the European Central Bank’s policy of guaranteeing eurozone members’ sovereign debt, expanding its balance sheet, and lowering interest rates. Bondholders gain when interest rates fall. But unemployment continues to rise in the heavily indebted southern countries, and output continues to lag behind Germany and other northern European countries.

The main reason for the lag is not simply low demand or large debts. There is a vast difference between unit labor costs – real wages adjusted for productivity – in Germany and in the heavily indebted southern countries. When the crisis began, production costs in Greece were about 30% higher than in Germany, so Greece exported very little and imported very much. Production costs in other heavily indebted countries were 20-25% higher than in Germany.

Growth will not resume until production costs in the indebted countries decline, which requires either a substantial permanent increase in productivity, a reduction in real wages, or both. While some adjustment has occurred, much of the change is not permanent. Austerity reduced the number of employed workers, particularly those with low skill and productivity levels. But gains in measured productivity growth from this source are not permanent changes, so a large part of the reported reductions in unit labor costs are temporary.

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